One of the most frequently asked questions, especially for new investors, is what should I do first, open a traditional IRA, which is Door #1, or a Roth IRA, which is Door #2?
First of all, it’s generally a good idea for most investors to consider saving for their retirement as soon as possible. They can do it either through a Roth IRA or a traditional IRA. You can also use a combination of both, as long as they meet the total contribution limits.
However, for those that work for an employer that has a 401(k) plan or a similar pension plan, it’s best to contribute to that plan before pursuing the IRA route. I recommend this because many companies match your contributions, which is free money for your retirement.
Now getting back to the question, do I first look to contribute to a traditional IRA in Door #1 or to a Roth IRA in Door #2?
Here are some quick pointers to be aware of before you make a selection of the two options. As an important note, the rules are being adjusted all the time so it is best to check with your tax professional to see if you fit the eligibility requirements based on your tax status.
Traditional IRA – (Door #1) This method allows you to put money away on a pre-tax basis and it grows tax-deferred. However, you are not allowed to withdraw the funds until you are 59½. At that point, assuming you have followed the rules, the withdrawal will be taxed at your income rate at that time, which may be lower based on your income circumstances. Plus, there is also no salary limits in contributing to your IRA like it is for the Roth IRA. However, you are not permitted to make any more contributions after the age of 70½. At that age, you must start making withdrawals from your account or else you will be penalized by the government.
Roth IRA – (Door #2) In using this method, you contribute post-tax dollars and the money will grow tax-free in your account for life. This means you won’t have to pay taxes on withdrawals in the future. However, you are not able to make any withdrawals (unapproved) until after the age of 59½. Another benefit to having a Roth IRA is that there is no mandatory age in which you have to start taking withdrawals like there is with a traditional IRA.
However, there are some income qualifications you need to consider when opening a Roth IRA. Your tax filing status will determine your eligibility category. Currently, if you have an adjusted gross income of $116,000 and below, you can contribute the maximum amount ($5500) and ($1000) more if you are 50 and older, giving you a total of $6500. If you are married and are filing your taxes jointly, your adjusted income cannot exceed $183,000.
Given its income qualifications, I recommend a Roth IRA for people starting off their careers since their salary will probably be low enough to meet the salary constraints.
Additionally, it’s important to state that your IRA contributions must come from wages from your job. As a result, you are not permitted to fund your IRA with donations from others. Also, starting January of the calendar year, you have 15 months to contribute to both your traditional IRA and your Roth IRA, which is an outstanding feature to have for late decision makers. This means the deadline for making contributions for 2015 are up to the regular tax filing date of April 15, 2016.
Plus, in regards to some new changes implemented specifically for Roth IRAs, if you have an account for five years, you will be eligible to make hardship withdrawals without penalty for the following purposes:
1) Tuition fees
2) Extreme medical expenses
3) Down payment for first-time home buyers
4) Special disability circumstances
5) Pay insurance premiums if you have been unemployed for an extended period
However, it is best that you check with (IRS,590) to get the exact details, as there are always new modifications to this rule. If you are still unsure of how your tax situation will be affected, you should discuss this with your tax professional if you need more clarification.
In closing, I hope that you have learned why investing in a traditional IRA or Roth IRA would be a good way to get started with your retirement plans. Again, the most important part of retirement planning is getting started. The sooner you begin this journey of wealth building, the closer you will be to having a nice nest egg waiting for you at retirement. The people who fail to put money away now will regret it in the future. I hope that this note will inspire you to invest today in your retirement if you haven’t already.